Traditional reinsurers challenged to compete on cost-of-capital

Traditional reinsurance companies are being challenged to compete with insurance-linked securities (ILS), catastrophe bonds and collateralized reinsurance products which have a lower cost-of-capital than them, according to GC Securities.

Capital inflows into the reinsurance space from third-parties and capital market investors are still rising. This has been pushing pricing down both on traditional reinsurance and non-traditional risk transfer solutions, resulting in the traditional reinsurance business model coming under increasing pressure.

GC Securities, the capital markets and broker-dealer unit of reinsurance broker Guy Carpenter and a division of MMC Securities Corp, has published its fourth-quarter 2013 catastrophe bond and ILS market report this morning. In the report GC Securities highlights that the pressure on traditional reinsurers has been rising, but they are finding ways to make the lower cost of third-party reinsurance capital play to their strengths as well.

GC Securities report discusses the continued influence from direct capital markets’ participation in reinsurance programs, which alongside a year of below average global catastrophe insured losses in 2013, put significant pressure on global catastrophic reinsurance pricing.

The reduced pricing, which was perhaps led by the catastrophe bond market and capital markets appetite for catastrophe risk to some degree, helped the catastrophe bond market to a strong year of issuance, with GC Securities recording $7.1 billion of new property & casualty catastrophe bonds issued in 2013. GC Securities number is lower than the $7.64 billion Artemis reported as it does not include every transaction recorded in the Artemis Deal Directory.

The fourth quarter of 2013 saw catastrophe bond issuance of $1.82 billion, according to GC Securities, again a slightly lower figure than the $1.877 billion Artemis recorded. This issuance was offset slightly by catastrophe bond maturities of $360m which lifted risk capital outstanding by $1.46 billion on GC Securities data.

As a result of a strong final quarter of growth for the cat bond market, GC Securities put total risk capital outstanding at the end of 2013 at an all-time high of $18.58 billion. Again, lower than the $20.5 billion recorded by Artemis. GC Securities estimates that the size of the outstanding cat bond market accounted for approximately 16% of global property catastrophe limit purchased annually.

The capital markets pressured reinsurance pricing through the first three-quarter of 2013, but traditional reinsurers responded to protect their market share by offering attractive pricing, expanded structural features and in some cases, collateralized capacity and/or limited multi-year capacity, according to GC Securities.

This produced buyers market conditions in traditional reinsurance, which resulted in some primary insurers bringing forwards their reinsurance renewals to take advantage of reinsurance with improved terms and lower prices.

Despite the fight back, the ILS and capital market continued to see strong activity with catastrophe bonds coming to market through to year-end and fourth-quarter cat bond issuance was aligned with previous years.

“Overall, 2013 included seven new sponsors who collectively secured $1.46 billion of catastrophe bond capacity,” commented Cory Anger, Global Head of Insurance-Linked Securities for GC Securities. “In addition to these new sponsors, another prevalent change in the market was the increasing use and acceptance of indemnity-based triggers. Given that spreads have tightened between indemnity and other trigger types, sponsors were inclined to take advantage of investors’ openness to indemnity triggers to reduce coverage basis risk without a material increase in pricing relative to non-indemnity trigger pricing.”

Traditional reinsurers are having to adjust to a reinsurance market which now contains a significant amount of lower cost capital from collateralized players and capital market investors. This has resulted in some reinsurers feeling the need to compete more directly with the capital markets, by bringing institutional money into their own underwriting strategies and establishing their own third-party reinsurance capital management facilities.

GC Securities said that traditional reinsurers are hedging their bets and creating their own capital markets units, allowing them to attract, manage and deploy third-party capital within their underwriting. This tends to be in the form of managing ILS funds, managed accounts or sidecars, GC Securities said, although we are now also seeing third-party capital backed reinsurers forming, as with the recent Watford Re, which perhaps signals another stage in the evolution of this trends.

By embracing third-party capital, bringing it under their management and into their underwriting business, traditional reinsurers can benefit from an opportunity to securitize the most capital-intensive parts of the business while providing valuable cost-efficient capacity on other business lines, said GC Securities.

“The growing influence of alternative markets capacity is pressuring traditional reinsurers’ business model and challenging them to compete against a model with lower-cost of capital that continues to enter the reinsurance market,” said Chi Hum, Global Head of Distribution for ILS for GC Securities.

Looking ahead, GC Securities said that despite the significant reduction in ILS pricing over the last year, investor demand for the ILS and catastrophe bond asset class remains strong. ILS managers continue to see the opportunity to bring large amounts of new capital to the reinsurance space, but many remain on soft-close as they wait for reinsurance market conditions to improve and opportunities to deploy more capital to emerge.

Chi Hum continued; “As the catastrophe bond market continues to mature, more new sponsors are looking to the alternative market space for meaningful capacity and we expect that this trend is likely to continue through 2014.”

This strong investor demand for ILS, catastrophe bonds and access to reinsurance risks continues to bring opportunities to insurers that elect to use capital markets capacity within their reinsurance programs. The demand also provides opportunities to ILS managers should some kind of market dislocation result in new capital deployment opportunities.

The demand from investors for insurance and reinsurance linked investments is now also benefitting those reinsurers who have actively embraced third-party money, and they too will stand to benefit should capital deployment opportunities emerge after large losses or other market dislocation.

So while reinsurers are certainly being challenged by lower cost capital from third-parties and the capital markets on one hand, they are also seeing opportunities emerge. The gap between the profitability of managing their own equity capital, versus managing third-parties, is the question that will soon have to be answered and once again issues such as expense ratios may be highlighted at some reinsurers in future results.

The coming months and maybe years look set to be particularly interesting as the cost-of-capital in reinsurance plays an increasingly important role in the marketplace.

You can access the full report from GC Securities here.